Dr.

Hamid U Bhuiyan

WORKING CAPITAL MANAGEMENT

 Working Capital Management
Working Capital Management involves decisions
about the optimal overall level of current assets
and the optimal mix of short-term and long-term
funds used to finance the company’s assets.

These decisions require an analysis of the risk and

expected return trade-offs associated with the
various alternative policies.
 Working Capital Management
Working capital management is a continuing process that involves
a number of day-today operations and decisions that determine
the following:

 The firm’s level of current assets

 The proportions of short-term and long-term debt the firm will

use to finance its assets

 The level of investment in each type of current asset

 The specific sources and mix of short-term credit (current

liabilities) the firm should employ
 Working Capital Policy
Working Capital Policy involves decisions about a
company’s current assets and current liabilities— what
they consist of, how they are used, and how their mix
affects the risk versus return characteristics of the
company.
Both the terms working capital and net working capital
normally denote the difference between the company’s
current assets and current liabilities.
The two terms are often used interchangeably.
 Working Capital Policy

 Working capital policies, through their effect on the

firm’s expected future returns and the risk associated
with these returns, ultimately have an impact on
shareholder wealth.

 Effective working capital policies are crucial to a firm’s

long-run growth and survival. If, for example, a
company lacks the working capital needed to expand
production and sales, it may lose revenues and profits.
 Working Capital Policy

 Working capital is used by firms to maintain

liquidity, that is, the ability to meet their cash

obligations as they come due.

 Otherwise, it may incur the costs associated with

a deteriorating credit rating, a potential forced

liquidation of assets, and possible bankruptcy.

Current Asset Investment Policy
 Current Asset Investment Policy
Relaxed Current Asset Investment Policy: Relatively large
amounts of cash, marketable securities, and inventories
are carried; and a liberal credit policy results in a high
level of receivables.
Restricted Current Asset Investment Policy: Holdings of
cash, marketable securities, inventories, and receivables
are constrained.
Moderate Current Asset Investment Policy: Between the
relaxed and restricted policies.
DuPont Equation
 Current Asset Investment Policy &
influence on ROE
A restricted (lean-and-mean) policy means a low level
of assets (hence, a high total assets turnover ratio),
which results in a high ROE, other things held
constant. However, this policy also exposes the firm
to risks because shortages can lead to work
stoppages, unhappy customers, and serious long-run
problems.
 Current Asset Investment Policy &
influence on ROE

The relaxed policy minimizes such operating

problems; but it results in a low turnover, which in
turn lowers ROE.

The moderate policy falls between the two extremes.

The optimal strategy is the one that maximizes the

firm’s long-run earnings and the stock’s intrinsic
value.
 Current Asset Financing Policy
 Current Assets Financing Policy: The way current assets are
financed.
 Maturity Matching, or ―Self-Liquidating,‖ Approach: A financing
policy that matches asset and liability maturities. Under this
method all of the fixed assets plus the permanent current assets are
financed with long-term capital, but temporary current assets are
financed with short-term debt.
For example, Inventory expected to be sold in 30 days would be
financed with a 30-day bank loan, a machine expected to last for 5
years would be financed with a 5-year loan, a 20-year building
would be financed with a 20-year mortgage bond, and so forth.
This is a moderate policy.
 Current Asset Financing Policy
Two factors prevent an exact maturity matching:

(1) There is uncertainty about the lives of assets.

For example, a firm might finance inventories with a 30-day bank loan,
expecting to sell the inventories and use the cash to retire the loan. But
if sales are slow, the cash would not be forthcoming and the firm might
not be able to pay off the loan when it matures.

(2) Some common equity must be used, and common equity has
no maturity.
Still, when a firm attempts to match asset and liability maturities, this is
defined as a moderate current asset financing policy.
 Current Asset Financing Policy
 Aggressive Approach: Firms finances some of its
permanent assets with short-term debt.

The reason for adopting the aggressive policy is to

take advantage of the fact that the yield curve is
generally upward-sloping; hence, short-term
rates are generally lower than long-term rates.
However, a strategy of financing long-term
assets with short-term debt is really quite risky.
 Current Asset Financing Policy

 Conservative Approach: Firms uses long-term

capital to finance all the permanent assets and to
meet some of the seasonal needs.
In this situation, the firm uses a small amount of
short-term credit to meet its peak requirements, but
it also meets part of its seasonal needs by ―storing
liquidity‖ in the form of marketable securities.
Current Asset Financing Policy
Current Asset Financing Policy
Current Asset Financing Policy
 Choosing between the Approaches

Because the yield curve is normally upward-sloping, the cost of

short-term debt is generally lower than that of long-term debt.

However, short-term debt is riskier to the borrowing firm for two

reasons:

a. If a firm borrows on a long-term basis, its interest costs will be

relatively stable over time. But if it uses short-term credit, its
interest expense can fluctuate widely, perhaps reaching such
high levels that profits are extinguished.
 Choosing between the Approaches
(2) If a firm borrows heavily on a short-term basis, a temporary
recession may adversely affect its financial ratios. If the
borrower’s financial position is weak, the lender may not
renew the loan, which could force the borrower into
bankruptcy.

On the other hand, short-term loans can generally be negotiated

much faster than long-term loans, moreover, short-term debt
may offer greater flexibility. If the firm thinks that interest
rates are abnormally high, it may prefer short-term credit to
gain flexibility in changing the debt contract.
 Choosing between the Approaches
Finally, long-term loan agreements generally contain provisions, or
covenants, that constrain the firm’s future actions in order to protect
the lender, whereas short-term credit agreements generally have fewer
restrictions.

All things considered, it is not possible to state that long-term or short-term

financing is better than the other.

The firm’s specific conditions will affect the choice, as will the preferences
of managers. Optimistic and/or aggressive managers will probably lean
more toward short-term credit to gain an interest cost advantage, while
more conservative managers will lean toward long-term financing to
avoid potential renewal problems.
 Cash Management
 Cash and marketable securities are the most liquid of a
company’s assets. Cash is the sum of the currency a
company has on hand and the funds on deposit in bank
checking accounts.

 Cash is the medium of exchange that permits

management to carry on the various functions of the
business organization. In fact, the survival of a company
can depend on the availability of cash to meet financial
obligations on time.
 Cash Management

 Marketable securities consist of short-term

investments a firm makes with its temporarily
idle cash. Marketable securities can be sold
quickly and converted into cash when
needed. Unlike cash, however, marketable
securities provide a firm with interest income.
 Management of Cash
 Effective cash and marketable securities management is
important in contemporary companies, government agencies,
and not-for-profit enterprises.
 Corporate treasurers continually seek ways to increase the yields
on their liquid cash and marketable security reserves.
 Traditionally, these liquid reserves were invested almost
exclusively in negotiable certificates of deposit, Treasury bills,
commercial paper, and repurchase agreements (short-term
loans backed by Treasury securities).
 Risk-Return Trade-offs
In recent years many treasurers have shown a willingness to take some
additional risks to increase the return on liquid assets. Financial
managers constantly face these types of risk–return trade-offs.

However, Many firms hold significant cash and marketable securities

balances. For example, at the end of 2003, Ford had a cash balance of
nearly $26 billion. Microsoft’s cash balance was $56 billion and
growing (i.e., free cash flow) at a rate of $1 billion per month.

These cash balances give the firm a cushion to handle economic

downturns and the ability to make investments in other firms when the
price is attractive
 Cash Management Function

The cash management function is concerned with

determining
 The optimal size of a firm’s liquid asset balance

 The most efficient methods of controlling the

collection and disbursement of cash
 The appropriate types and amounts of short-
term investments a firm should make
 Reasons for Holding Cash
 Transactions motive:
 Transactions related needs come from normal
disbursement and collection activities of the firm.
 The disbursement of cash includes the payment of wages
and salaries, trade debts, taxes, and dividends.
 The cash inflows (collections) and outflows
(disbursements) are not perfectly synchronized, and some
level of cash holdings is necessary to serve as a buffer.
 Perfect liquidity is the characteristic of cash that allows it
to satisfy the transactions motive.
 Reasons for Holding Cash

 Precautionary Motive: Future cash flows and

the ability to borrow additional funds on
short notice are often uncertain, liquid asset
balances are necessary to meet unexpected
requirements for cash.
 Reasons for Holding Cash

 Future Requirements: Liquid asset balances are held

to meet future requirements, which include fixed
outlays required on specific dates, such as quarterly
dividend and tax payments, capital expenditures, and
repayments of loans or bond issues.
 A firm also may hold as liquid assets the proceeds
from a new debt or equity securities offering prior to
using these funds for expansion.
 Reasons for Holding Cash

Speculative Motive: Some firms build up large cash balances in

preparation for major acquisitions, additional investment
opportunities, exercise bargain purchase options, attractive
interest rate, favorable exchange rate fluctuations, etc.

For example, in early 1999, Ford Motor Company built up its

liquid asset balances to nearly $24 billion. What Ford did? It
acquired Volvo for $6.5 billion. The large cash balances gave
Ford timing flexibility in pursuing acquisitions.
 Reasons for Holding Cash

Compensating Balances: Firms generally has

to hold cash balances to compensate its bank
(or banks) for the services provided.
 Cost of Holding Cash
Costs in dollars of
holding cash Trading costs increase when the firm
must sell securities to meet cash
needs.
Total cost of holding cash
Opportunity
Costs

Trading costs

Size of cash balance

 Cash Conversion Cycle
Cash Conversion Cycle (CCC) / Period: The length of time funds are tied
up in working capital or the length of time between paying for working
capital and collecting cash from the sale of the working capital.

Inventory Conversion Period: The average time required to convert raw

materials into finished goods and then to sell them.

Average Collection Period (ACP): The average length of time required to

convert the firm’s receivables into cash, that is, to collect cash following
a sale.

Payables Deferral Period: The average length of time between the

purchase of materials and labor and the payment of cash for them.
 Cash Conversion Cycle - Illustration
 Connex has been in business for several years and is now in a stable
position—placing orders, making sales, obtaining collections, and
making payments on a recurring basis. The following data were taken
from its latest financial statements:

Annual sales $1,216,666

Cost of goods sold 1,013,889

Inventory 250,000

Accounts receivable 300,000

Accounts payable 150,000

Determine the Cash Conversion Period of Connex

 Cash Conversion Cycle – Illustration
Inventory Conversion Period = Inventory / COGS Per
Day
 $250,000 / ($1,013,889 / 365) = 90 days
Receivable Collection Period = Receivables / Sales Per
Day
 $300,000 / ($1,216,666 / 365) = 90 days
Payable Deferral Period = Payables / Purchase Per Day
Or,
Payable Deferral Period = Payables / COGS Per Day
 $150,000 / ($1,013,889 / 365) = 54 days
 Cash conversion cycle CCC = 90 days + 90 days - 54
days = 126 days
 If Connex CCC is Higher than its Planned CCC. What
Steps its CFO should take?

The CFO should drive

 Sales people to speed up sales
 The credit manager to accelerate collections.
 The purchasing department should try to get longer payment
terms.

If Connex could take those steps without hurting sales and

operating costs, the firm would help its profits and stock
price.
Findings of Research in Working Capital Management

 Two professors, Hyun-Han Shin and Luc Soenen,

studied more than 2,900 companies over a 20-year
period.
 They found that shortening the cash conversion
cycle resulted in higher profits and better stock price
performances.
 Their study demonstrates that good working capital
management is important.
 Working Capital Policy - Illustration
 Calgary Company is thinking of modifying its working
capital assets policy. Fixed assets are $600,000, sales are
projected at $3 million, the EBIT/sales ratio is projected
at 15%, the interest rate is 10% on all debt, the federal-
plus state tax rate is 40%, and Calgary plans to maintain
a 50% debt-to-assets ratio. Three alternative current
asset policies are under consideration: 40%, 50%, and
60% of projected sales. What is the expected return on
equity under each alternative?
Working Capital Policy - Illustration
 Working Capital Policy - Illustration
Vanderheiden Press Inc. and Harrenhouse Publishing Company had the following
balance sheets as of December 31, 2008 (thousands of dollars):
VANDER HEIDEN HARRENHOUSE

Current assets $100,000 $ 80,000

Fixed assets (net) 100,000 120,000

Total assets $200,000 $200,000

Current liabilities $ 20,000 $ 80,000

Long-term debt 80,000 20,000

Common stock 50,000 50,000

Retained earnings 50,000 50,000

Total liabilities and equity $200,000 $200,000

 Working Capital Policy - Illustration
Earnings before interest and taxes (EBIT) for both firms are $30 million,
and the effective federal plus- state tax rate is 40%.

Required:

a. What is the return on equity for each firm if the interest rate on current
liabilities is 10% and the rate on long-term debt is 13%?

b. Assume that the short-term rate rises to 20%. While the rate on new
long-term debt rises to 16%, the rate on existing long-term debt
remains unchanged. What would be the returns on equity for
Vanderheiden Press and Harrenhouse Publishing under these
conditions?

c. Which company is in a riskier position? Why?

Working Capital Policy - Illustration
Working Capital Policy - Illustration
 Primrose Corp has $15 million of sales, $2 million of
inventories, $3 million of receivables, and $1 million of
payables. Its cost of goods sold is 80% of sales, and it finances
working capital with bank loans at an 8% rate. What is
Primrose’s cash conversion cycle (CCC)? If Primrose could
lower its inventories and receivables by 10% each and increase
its payables by 10%, all without affecting sales or cost of goods
sold, what would be the new CCC, how much cash would be
freed up, and how would that affect pretax profits?
Zocco Corporation has an inventory conversion period of 75
days, an average collection period of 38 days, and a
payables deferral period of 30 days.

a. What is the length of the cash conversion cycle?

b. If Zocco’s annual sales are $3,421,875 and all sales are on

credit, what is the investment in accounts receivable?

c. How many times per year does Zocco turn over its
inventory?
Prestopino Corporation produces motorcycle batteries. Prestopino turns
out 1,500 batteries a day at a cost of $6 per battery for materials and
labor. It takes the firm 22 days to convert raw materials into a battery.
Prestopino allows its customers 40 days in which to pay for the
batteries, and the firm generally pays its suppliers in 30 days.

a. What is the length of Prestopino’s cash conversion cycle?

b. At a steady state in which Prestopino produces 1,500 batteries a day,

what amount of working capital must it finance?

c. By what amount could Prestopino reduce its working capital financing

needs if it was able to stretch its payables deferral period to 35 days?
d. Prestopino’s management is trying to analyze the effect of a proposed
new production process on its working capital investment. The new
production process would allow Prestopino to decrease its inventory
conversion period to 20 days and to increase its daily production to
1,800 batteries. However, the new process would cause the cost of
materials and labor to increase to $7. Assuming the change does not
affect the average collection period (40 days) or the payables deferral
period (30 days), what will be the length of its cash conversion cycle
and its working capital financing requirement if the new production
process is implemented?
Cranberry Manufacturing Company is considering the following two
alternative working capital investment and financing policies:
Policy A Policy B
Current assets ÷ Sales 60% 40%
Short-term debt ÷ Total debt 30% 60%

Forecasted sales next year are $150 million. EBIT is projected to be 20

percent of sales. The company’s income tax rate is 40 percent. Fixed
assets are $100 million. Cranberry wishes to maintain its current
capital structure, which consists of 60 percent debt and 40 percent
equity. Interest rates on the company’s short-term and long-term debt
are 10 and 14 percent, respectively.

a. Determine the expected rate of return on equity under each of the

working capital policies.
b. Which working capital policy is riskier? Explain.